On Financial Stocks and Portfolio Risk

Tom Brown recently posted a rebuttal to Jason Zweig’s Wall Street Journal column. Geoff Gannon also wrote a great follow-up article with more on Benjamin Graham. I suggest reading all three articles.

In this post, I wanted to comment on a few aspects of Tom Brown’s argument, some of which I have been thinking about lately. The following is a quote from Tom’s post:

True value investors, by contrast, tend not to worry what might happen in the interim. Instead, they come up with their best estimate of a financial company’s intrinsic value by estimating the magnitude of likely losses along with its “normalized” earnings level two or three years out. They then compare that estimate of intrinsic value with the stock’s price today. Zweig says such estimates are impossible. I disagree.

I have always enjoyed Tom’s posts, but I can see a few problems with the above statement. (As a disclaimer, I know relatively little about financial companies, as they are out of my circle of competence. I hold no interest in any financial beside Berkshire Hathaway.)

First observation:
With highly leveraged financial companies, what happens in the “interim” can not only hurt you, it can kill you. Compare a bank to a retailer. Let’s say that you find a cheap retailer, where you estimate normalized earnings a few years out to derive its value. Assuming your estimate is correct, you should be able to ride out any short-term volatility to obtain the long-term value of the company. Like Tom says, that is the foundation of value investing. Continue reading “On Financial Stocks and Portfolio Risk”

Ed Thorp & Over-betting

In today’s Wall Street Journal, there’s a great interview with Edward Thorp and Bill Gross.

Both investors are asked about current market conditions and their thoughts on investing in general.

Ed Thorp is a hedge fund manager who ran Princton-Newport Partners and has returns of 20% over a 28-year period (ending 1998). In addition to his investing skills, Thorp is best known for his work at the Blackjack tables. In 1962, he authored the book Beat the Dealer, which explained the methods he used to win at Blackjack.

For more information on Ed Thorp, check out the book Fortune’s Formula. It’s a great read that details the evolution of information theory, the Kelly Criterion, gambling strategies, hedge funds, and the mob’s involvement in all of the above. Math, gambling, the mafia, and investing. Who could ask for anything more? Also, if you’re interested in Thorp’s Blackjack strategies (card counting), the book Bringing Down the House is another great read. But I’ll stick to the subject of investing for this post.


Below is a section from the WSJ article where Gross and Thorp discuss hedge funds: Continue reading “Ed Thorp & Over-betting”